UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT
CENTER FOR
INTERNATIONAL
DEVELOPMENT
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UNITED NATIONS
G-24 Discussion Paper Series
Exchange-rate Policies for Developing
Countries: What Have We Learned?
What Do We Still Not Know?
Andrés Velasco
No. 5, June 2000
UNITED NATIONS CONFERENCE ON
TRADE AND DEVELOPMENT
CENTER FOR INTERNATIONAL DEVELOPMENT
HARVARD UNIVERSITY
G-24 Discussion Paper Series
Research papers for the Intergovernmental Group of Twenty-Four
on International Monetary Affairs
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Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
PREFACE
The G-24 Discussion Paper Series is a collection of research papers prepared
under the UNCTAD Project of Technical Support to the Intergovernmental Group of
Twenty-Four on International Monetary Affairs (G-24). The G-24 was established in
1971 with a view to increasing the analytical capacity and the negotiating strength of the
developing countries in discussions and negotiations in the international financial
institutions. The G-24 is the only formal developing-country grouping within the IMF
and the World Bank. Its meetings are open to all developing countries.
The G-24 Project, which is administered by UNCTAD’s Macroeconomic and
Development Policies Branch, aims at enhancing the understanding of policy makers in
developing countries of the complex issues in the international monetary and financial
system, and at raising the awareness outside developing countries of the need to introduce
a development dimension into the discussion of international financial and institutional
reform.
The research carried out under the project is coordinated by Professor Dani Rodrik,
John F. Kennedy School of Government, Harvard University. The research papers are
discussed among experts and policy makers at the meetings of the G-24 Technical Group,
and provide inputs to the meetings of the G-24 Ministers and Deputies in their preparations
for negotiations and discussions in the framework of the IMF’s International Monetary
and Financial Committee (formerly Interim Committee) and the Joint IMF/IBRD
Development Committee, as well as in other forums. Previously, the research papers for
the G-24 were published by UNCTAD in the collection International Monetary and
Financial Issues for the 1990s. Between 1992 and 1999 more than 80 papers were
published in 11 volumes of this collection, covering a wide range of monetary and financial
issues of major interest to developing countries. Since the beginning of 2000 the studies
are published jointly by UNCTAD and the Center for International Development at
Harvard University in the G-24 Discussion Paper Series.
The Project of Technical Support to the G-24 receives generous financial support
from the International Development Research Centre of Canada and the Governments of
Denmark and the Netherlands, as well as contributions from the countries participating
in the meetings of the G-24.
iii
EXCHANGE-RATE POLICIES FOR DEVELOPING
COUNTRIES: WHAT HAVE WE LEARNED?
WHAT DO WE STILL NOT KNOW?
Andrés Velasco
New York University,
University of Chile and
National Bureau of Economic Research
G-24 Discussion Paper No. 5
June 2000
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
Abstract
The 1997–1998 Asian crisis, with its offshoots in Eastern Europe and Latin America, has
reignited the debate about appropriate exchange-rate policies for developing countries. One
widely shared conclusion from this episode is that adjustable or crawling pegs are extremely
fragile in a world of volatile capital movements. The pressure resulting from massive capital
flow reversals and weakened domestic financial systems was too strong even for countries that
followed sound macroeconomic policies and had large stocks of reserves. As a consequence, the
polar regimes of a “hard pegs” (such as a currency board), or a clean float, are enjoying new
popularity.
This paper argues that, while currency boards or even dollarization may be justified in some
extreme cases, they are not appropriate for all developing countries. The recommendations
formulated on the basis of the Mundell-McKinnon criteria for the optimum currency are
considered still sensible today. Currency boards face serious implementation problems. One is
the choice of the currency to peg to and at what rate; another is the need to ensure stability of
the domestic financial system in the absence of a domestic lender of last resort.
Floating appears to have wider applicability. As Friedman already argued in the early 1950s,
if prices move slowly, it is both faster and less costly to move the nominal exchange rate in
response to a shock that requires an adjustment in the real exchange rate. But for exchange-rate
flexibility to be stabilizing, it has to be implemented by independent central banks whose
commitment to low inflation is credible. Ongoing depreciations that follow from imprudent of
opportunistic monetary behaviour will surely come to be expected by agents, and hence will
have no real effect; occasional depreciations that respond exclusively to unforecastable shocks
will, almost by definition, have real effects. But floating also faces questions of implementation.
Given that no central bank completely abstains from intervention in currency markets, what
principles should govern such intervention? The paper elaborates on a number of points in this
regard on which recent experience is likely to be instructive, but on which more research is
needed.
Finally, any exchange-rate regime, and especially one of flexible rates, requires complementary policies to increase its chances of success. In this context, some have suggested the use
of capital controls; less controversial is the need for prudential regulation of the financial
system and for counter-cyclical fiscal policy.
vii
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
ix
Table of contents
Page
Preface
............................................................................................................................................ iii
Abstract
........................................................................................................................................... vii
I. The new conventional wisdom ................................................................................................ 1
II. Hard pegs: advantages, prerequisites and pitfalls ................................................................ 3
A. The credibility argument ...................................................................................................... 3
B. The discipline argument ....................................................................................................... 3
C. Prerequisites for adoption .................................................................................................... 4
D. Pegging to the right currency ............................................................................................... 5
E. Combining exchange rate and financial stability ................................................................. 5
III. Can exchange-rate flexibility help? ........................................................................................ 6
A. The basic case for flexibility ............................................................................................... 6
B. Credibility versus flexibility ................................................................................................ 7
C. Politics and policy-making .................................................................................................. 8
D. Exchange-rate flexibility and financial stability .................................................................. 9
IV. Making exchange-rate flexibility work in practice ............................................................. 10
A. Nominal anchors and inflation targets ............................................................................... 10
B. Dealing with short-term exchange-rate fluctuations .......................................................... 11
C. Dealing with long swings in the exchange rate ................................................................. 11
D. Crafting monetary policy ................................................................................................... 12
V. Complementary policies: financial regulation, capital controls and fiscal institutions ........ 13
A. Financial liberalization and fragility .................................................................................. 13
B. Capital inflows and short-term debt................................................................................... 14
C. Improving fiscal institutions .............................................................................................. 14
Notes
........................................................................................................................................... 14
References
........................................................................................................................................... 15
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
1
EXCHANGE-RATE POLICIES FOR DEVELOPING
COUNTRIES: WHAT HAVE WE LEARNED?
WHAT DO WE STILL NOT KNOW?*
Andrés Velasco
I.
The new conventional wisdom
The 1997–1998 Asian crisis, with its offshoots
in Eastern Europe and South America, revealed how
little we still know about workable exchange-rate
policies for developing countries. Arrangements that
had performed relatively well for years (think of
Indonesia and the Republic of Korea) came crashing
down with almost no advance notice; other arrangements that once seemed invulnerable (think of Hong
Kong’s currency board) almost tumbled down as well.
Mid-course corrections and policy changes proved
equally troublesome: in every country that abandoned
a peg and floated (Brazil, Ecuador, Russian Federation and Thailand, and again Indonesia and Republic
of Korea) the exchange rate overshot massively, and
a period of currency turmoil followed. And all of it,
of course, with tremendous real costs: both the high
interest rates used to defend pegs and the massive
depreciations that followed abandonment played
havoc with corporate balance sheet and wrecked large
chunks of the domestic financial system.
But in spite of the confusion, pundits have not
been shy about drawing conclusions. Past financial
and currency crises bred new bits of conventional
wisdom, many of which were discarded when the
next crash hit; this latest meltdown is no exception.
With analysts scrambled to extract a new set of policy
*
Parts of this document draw on Larrain and Velasco (1999).
lessons, no tenet of conventional wisdom is more
pervasive than the “law of the excluded middle”:
there is apparently no intermediate exchange-rate
regime suitable for developing countries. Currency
boards or free floating are, allegedly, the only options.
The reasoning behind this fashionable conclusion is simple. Adjustable or crawling pegs were in
place in almost every country that recently experienced serious difficulties: Brazil, Ecuador, Indonesia,
Republic of Korea, Russian Federation and Thailand.
The pressure brought by massive capital flow reversals and weakened domestic financial systems was
too much to bear, even for countries that followed
reasonably sound macro policies and had seemingly
plentiful reserves.
If lack of credibility and the resulting endemically high interest rates was one of the factors that
brought these pegs down, the logic goes, then the
answer is to ensure credibility at any expense: “hard
pegs” such as a currency board – or even full abandonment of the domestic currency – should help
convince sceptics. After all, one cannot easily devalue a currency that does not exist, or one whose
exchange rate is set by law. Or if the conditions for
such radical fixing are not present, one should go to
the other extreme and let the currency value fluctuate freely. The other way to ensure credibility is not
to make any promises about the exchange rate at all.
2
G-24 Discussion Paper Series, No. 5
As do most maxims of conventional wisdom,
this one has a good deal of truth in it. Revocable pegs,
whether of the crawling, adjusting or constant variety, appear indefensible in a world of high and volatile
capital mobility. If this was true for rich countries
with large reserves (Europe in 1991–1992), it is even
more true for middle-income, reserve-constrained,
developing countries.
But the new exchange rate orthodoxy also
leaves a great deal to be desired. Its empirical foundations, for one, are weak. A good deal of the current
enthusiasm for currency boards owes to the experience of one country, Argentina, over a fairly brief
period of time. All the other experiences, except
for Hong Kong’s, have been too short-lived to be
informative.1 The endorsement of free floating similarly glosses over the fact that there are no central
banks in the world that completely abstain from intervention in the currency market. When assessing
empirically the virtues of floating, therefore, one has
to look at mixed regimes that in many ways are not
too different from systems of wide intervention bands
or periodically adjustable pegs. Chile, Colombia,
Mexico and Peru are recent examples of this in Latin
America. And, overall, the jury is still out as to which
system – hard pegs or floating – performs better at
times of trouble. Early in the recent episode evidence
seemed to favour the Argentine/Hong Kong model:
a period of high interest rates seemed like a small
price to pay to avoid the turmoil affecting countries
that had let the exchange rate go. But both hard-peg
countries are today mired in major recessions, while
some of the early devaluers (Mexico, Republic of
Korea and Thailand) seem to be back on the growth
track. The enthusiasm for currency boards has diminished accordingly.
The second shortcoming of the new orthodoxy
is that it leaves it quite unclear which countries should
adopt which polar system. Once upon a time economists familiar with the Mundell-McKinnon criteria
for optimum currency areas confidently recommended fixed exchange rates to small economies
wide open to international trade (Mundell, 1961).
Large economies, or small economies subjected to
shocks uncorrelated to those buffeting the country
to whose currency they might have pegged, were
advised to choose flexible rates. This prescription is
not antediluvian – it was contained, for instance, in
a special chapter on the subject in the 1997 IMF
World Economic Outlook. But in the midst of their
respective crises there was no shortage of pundits
advising Brazil and the Russian Federation (not exactly small countries) to adopt currency boards, as if
short-term credibility considerations should necessarily take precedence over all other considerations.
That may well be so, but the abdication of monetary
independence should be chosen after a careful examination of pros and cons, not as a last-ditch effort
to arrest economic collapse.
And there is, finally, the pesky problem of implementation. One question is not whether to float
freely, but what kind of “dirty” float to have. Should
there be a “monitoring band”, as Williamson (1998)
has suggested and some countries seem to employ in
practice? Should monetary policy react systematically (either via aggregates or interest rates) to
movements in nominal or real exchange rates? Is an
inflation target the best way to endow flexible systems with a nominal anchor?
Currency boards also face serious implementation problems of their own. Start with the choice of
what currency to peg to and at what rate. Pegging to
the wrong anchor in a world of great volatility in the
cross-rates among the three major currencies can be
devastating, as the countries of South-East Asia recently discovered. And how to guarantee the stability
of the domestic financial system in the absence of a
domestic lender of last resort? A foreign alternative
presumably has to be found.
In this paper I review these and related issues.
The goal is to highlight areas where more research is
necessary, both to clarify our understanding of complex problems and to help guide sound policy-making
in developing countries. Throughout, the emphasis
is on designing exchange-rate systems for middleincome developing countries with reasonably modern
financial systems and relatively high degrees of integration into world capital markets – that is, what is
today fashionably known as “emerging markets”. Lowincome countries face quite a different set of issues.
Section II below focuses on the costs and benefits of currency boards, and tries to identify the
relatively stringent conditions under which it is prudent to adopt such an arrangement. Section III tries
to answer the question of whether regimes with substantial exchange-rate flexibility can be effective
counter-cyclical stabilizers in developing countries.
Section IV studies how to make flexibility work in
practice, with special attention to inflation targets
and alternative monetary policy rules. Section V focuses on useful complementary policies: prudential
banking regulation, taxes on short-term capital movements, and reforms to the institutions that govern
fiscal policy.
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
II. Hard pegs: advantages,
prerequisites and pitfalls
There is no doubt that in the aftermath of the
Asian crisis, hard pegs (especially currency boards)
are becoming increasingly popular. After reviewing
some of the theoretical arguments behind this popularity, I ask two sets of questions. What kind of
country is best served by adopting a hard peg? And
what pitfalls should the adopting country strive to
avoid?
A. The credibility argument
The main argument in favour of hard pegs rests
on the need to make monetary policy credible. If you
cannot build credibility for monetary policy at home,
then you can presumably import it by fixing the value
of your currency to a hard-money country. This is
what Club-Med countries attempted by pegging to
the deutsche mark, and what Argentina has tried with
the United States dollar. Many theoretical and practical objections to the argument are well known.
Where the political costs of abandoning a peg come
from and whether they are large enough to prevent
unpleasant surprises is less than clear. Many an “irreversible” peg has come undone; the problems of
the European Monetary System in the early 1990s
are but one example. Yet it also seems clear that if
the political will is sufficient and if the institutions
designed to express that will are robust enough, interest rate spreads and other indicators of the public’s
scepticism can come down sharply and stay there.
Europe in the run-up to the Economic and Monetary
Union is a good example.
The strength (and also the potential weakness)
of hard pegs lies in the absence of escape clauses. A
fixed exchange rate may be thought of as an implicit
contract in which the Central Bank commits itself to
retaining the peg unless one or more of several unspecified but painful factors kick in. If they do,
devaluation need not be punished by a loss of credibility, for in devaluing the authorities have adhered
to the implicit contract. When the short-term pain of
defending the peg is large enough to outweigh the
long-term benefits of retaining the fixed rates regime,
the country could exercise an “escape clause” or engage in “excusable devaluation”.
Whether this is a plausible view of the world
hinges on difficult implementation problems. It is not
clear whether there are “excusable devaluations” in
3
developing countries, just as there may not be “orderly devaluations” either. This is probably because
the exogenous shocks that could render them so are
not fully observable – or perhaps not even fully exogenous, in the sense that governments could try to
manipulate economic variables to justify an abandonment of the peg. When in doubt, a weary public
may justifiably choose to be sceptical.2
Obstfeld (1997) has raised an additional and
crucial argument against escape clauses in fixed exchange rates: they can open the door to multiple
equilibria. The government is allowed to devalue if
the situation gets too nasty. But the expectation that
the government might devalue could lead the private
sector to take actions (for example, by demanding
large wage increases and high nominal interest rates)
that could make the situation unpleasant to begin
with. If the government does not devalue, it has to
live with costly high real wages and real interest rates.
But if it gives in, we have a self-fulfilling prophecy
setting in: devaluation takes place exclusively because agents expected it. This means that a government should think long and hard before hinting that
it views devaluation in some circumstances as “excusable”. Equivalently, governments should adopt
hard pegs that make devaluation unthinkable.
B. The discipline argument
The other important reason that leads many to
advocate hard pegs is their alleged ability to induce
discipline – whether fiscal or monetary. This argument
is a close cousin of the credibility story. Presumably,
fixed rates induce more discipline because adopting
lax fiscal policies must eventually lead to an exhaustion of reserves and an end to the peg. Presumably,
the eventual collapse of the fixed exchange rate
would imply a big political cost for the policy maker
– that is to say, bad behaviour today would lead to a
punishment tomorrow. Fear of suffering this punishment leads the policy maker to be disciplined. If the
deterrent is strong enough, then unsustainable fiscal
policies do not occur in equilibrium.
But, as Tornell and Velasco (1998, 2000) have
argued, the conventional wisdom fails to understand
that under flexible rates imprudent behaviour –
especially fiscal laxity – has costs as well. The difference with fixed rates is in the intertemporal
distribution of these costs. Under fixed rates unsound
policies manifest themselves in falling reserves or
exploding debts. Only when the situation becomes
4
G-24 Discussion Paper Series, No. 5
unsustainable do the costs begin to bite. Flexible
rates, by contrast, allow the effects of unsound fiscal
policies to manifest themselves immediately through
movements in the exchange rate and the price level.
All of this means (as Tornell and Velasco 1998 and
2000 show formally) that if inflation is costly for the
fiscal authorities, and these discount the future heavily, then flexible rates, by forcing the costs of
misbehaviour to be paid up-front, can provide more
fiscal discipline.
Some empirical evidence supports this revisionist view. Tornell and Velasco (1998) and Gavin and
Perotti (1997) show that in Latin America fiscal policies have been more prudent – after controlling for a
host of factors – under flexible than under fixed rates.
Those were mostly “soft” pegs. Would hard pegs
perform any differently? The evidence in this regard
is limited. Tornell and Velasco (2000) study the case
of sub-Saharan Africa, comparing the experience of
Francophone countries that have pegged to the French
franc versus the rest. Since pegs in the CFA zone are
an artifact of colonial rule, they are supported by a
French commitment to intervene – and currency rates
have been changed only once since 1948; they could
conceivably be thought of as “hard”. The bad news
is that Francophone African countries operating under that regime seem, after controlling for a host of
factors, to have exhibited less fiscal discipline – defined as average deficits – than their Anglophone
counterparts.
The recent experience in Latin America is also
ambiguous. The fiscal performance of Argentina and
Panama has not been outstanding, but in the case of
Argentina it represents a vast improvement from
the hyper inflation-producing deficits of the 1980s.
Would free-spending Brazilian congressmen have
behaved more prudently in 1997–1998 had their
country been on a currency board? Some scepticism
is surely in order.
C. Prerequisites for adoption
Hard pegs therefore seem to have some important (though not unambiguous) advantages. But a
currency board or full dollarization are not for everyone. A short list of conditions should to include:3
•
Optimal currency areas criteria must be satisfied. This means, among other things, that large
countries are worse candidates than small countries, and that pegging to a country subject to
very asymmetric real shocks is likely to prove
problematic.
•
Also along Mundell-McKinnon lines, the bulk
of the adopting country’s trade takes place with
the country or countries to whose currencies it
plans to peg. This means that, ceteris paribus,
Mexico or Central America are much better
candidates for dollarization than Argentina,
Brazil or Chile. More on this below.
•
The adopting country must have preferences
about inflation that are broadly similar to those
of the country to which it plans to peg. This
may be easily achieved in countries with a history of high inflation, which now want price
stability at all costs (e.g. Argentina). It may
prove trickier in countries which have never
experienced a full-blown hyperinflation, and
where the polis is less unanimous in its willingness to take pains to ensure stable prices
(e.g. Brazil, Ecuador, Venezuela).
•
Flexible labour markets become essential: with
the exchange rate fixed, nominal wages and
prices must adjust, however slowly, in response
to an adverse shock. Countries considering a
hard peg are well advised to undertake labour
reforms first. The argument is sometimes made
(especially in Europe) that the very presence of
a hard peg will create the political impetus for
labour market deregulation. That may well be
so, but it seems like a very risky gamble to take,
especially for countries with political systems
more unwieldy than Europe’s.
•
Strong, well-capitalized and well-regulated
banks are also essential, since a hard peg prevents the local central bank from serving as a
lender of last resort to domestic banks. More
on this below.
•
Hard pegs are most necessary for countries with
weak central banks and chaotic fiscal institutions. But making hard pegs work requires
high-quality institutions, and the rule of law
matters in ways that are seldom discussed. A
currency board for instance, is a commitment
to adhere to a set of very strict rules governing
monetary policy. It may also involve putting the
exchange rate into the law, as Argentina has
done. These arrangements only make sense in
countries where governments adhere to their
own rules and where laws cannot be changed
by fiat.
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
D. Pegging to the right currency
A key implementation problem is that, in a
world of floating rates, pegging to one currency
means floating vis-à-vis most others. This is not a
problem for countries whose trade is geographically
very concentrated and which peg to the currency of
a large trading partner. But otherwise cross-rate fluctuations can do serious damage, as East Asian
economies whose currencies were pegged to the dollar discovered in 1997. The sharp appreciation of the
dollar vis-à-vis the yen caused substantial appreciation in the real effective exchange rates of several
East Asian countries, helping pave the way for the
crisis that followed (Corsetti et al., 1998). Of course,
part of the problem followed from the fact that these
countries pegged de facto or de jure to the dollar,
while their trade was quite diversified.
One way out is to peg not to a single currency
but to a basket. In principle, at least, this could help
insulate countries from cross-rate instability. But the
problems of implementation are many and difficult.
Under a currency board the weights used to calculate the basket would have to be public information;
this is not the way in which banks have traditionally
preferred to manage such baskets. There is also the
need to change the weights in response to structural
change. Who is to do that and according to what criteria? Discretional manipulation of weights can easily
become arbitrary even when done by independent
and respected central banks, as the recent experience
of Chile suggests.
Indeed, if simplicity, transparency and observability are the main virtues of a currency board,4
moving toward a complex and ever-changing basket
system may undermine the very foundations of the
policy. And, of course, pegging to a basket means
that pairwise exchange rates fluctuate as much as
international cross rates do, and this adds risk to certain kinds of transactions. Much of the appeal of
current Argentine policy comes from the constant
and one-for-one exchange rate, which all Buenos
Aires taxi drivers know and can brag about. A complex arrangement in which the price of the United
States dollar fluctuated unpredictably every day
might not command the same kind of support – and
would almost certainly not impose the same degree
of transparency upon monetary policy.
5
E. Combining exchange rate and
financial stability
The essence of a currency board is that it severely limits the ability of the authorities to extend
domestic credit. This may be good for preventing
inflation, but it can be bad for bank stability: under a
currency board or the gold standard, domestic banking is left without a lender of last resort, and in a
world of fractional banking and imperfect deposit
insurance this amounts to an invitation to self-fulfilling bank runs. A conclusion, couched in modern
language, that economists have known at least since
Bagehot: systems that tie the central bank’s hands
and prevent it from printing money, also prevent it
from coming to the rescue of banks at times of trouble. As Chang and Velasco (1998a) show formally
in a model of the Diamond and Dybvig (1983) type,
a currency board makes balance-of-payments crises
less likely only at the price of making bank crises
more likely. The price of low inflation may be endemic financial instability.
An alternative is to use fiscal instead of monetary policy for helping troubled banks. But since
developing countries are typically rationed at times
of crisis, it is not feasible for the government simply
to borrow against the present value of future tax receipts and then hand over the money to the bankers.
Ready help at times of trouble requires that the fiscal authority build, via sustained surpluses, a “war
chest” to be kept in liquid form. For a country to
“self-insure” its banking system in this way is, at least
in theory, perfectly possible but costly. Even if we
gloss over the political difficulties, the financial costs
are large. The following example is suggestive: imagine a country with M2 equal to two thirds of GDP,
which keeps half that amount in time deposits in
Zurich. Such deposits pay 50 basis points below
LIBOR, while domestic interest rates in the country
in question are 2.5 per cent above LIBOR. Hence,
the lower bound for the net cost of holding the war
chest is one per cent of GDP per annum.
Can the country do better by purchasing such
insurance abroad? After all, if lenders can diversify
away the risk of country-specific bank runs, such
insurance need not be expensive. This is presumably
the logic of the Argentine policy of contracting a line
of credit (for which a premium is paid annually) to
be used in case of bank troubles. The idea is appealing, but not without potential difficulties. First, if
there is regional or global contagion, the risk of bank
runs need not be easily diversifiable for lenders. Sec-
6
G-24 Discussion Paper Series, No. 5
ond, the obvious potential for moral hazard makes
such contracts hard to write and enforce. Third is the
issue of size: press accounts put the Argentine line
of credit at $6 billion, which is less than 10 per cent
of M2. Whether larger amounts may be provided by
the market at a reasonable premium is unclear.
Not everyone feels this is a problem. Dornbusch
(1998) wrote: “The counter argument that currency
boards or full dollarization sacrifice the lender of last
resort function are deeply misguided... Lender of last
resort can readily be rented, along with bank supervision, by requiring financial institutions to carry
off-shore guarantees”. But how exactly does one rent
such a lender? We saw that contingent credit lines
are not without problems. A currently fashionable
alternative is to encourage foreign ownership of domestic banks, hoping that equity holders abroad will
serve as lenders of last resort. Again, this is probably a good idea, but a completely untested one. Will
Citibank U.S. ride to the rescue every time that Latin
or Asian bank in which it has a 10 per cent equity
stake gets into trouble? Perhaps. But hanging a whole
financial system’s health on that conjecture seems
risky indeed.
III. Can exchange-rate flexibility help?
Currency boards and dollarization, then, are one –
but certainly not the only – way forward. The alternative is greater flexibility in exchange rates. That is
indeed the direction in which many developing countries, overwhelmed by the difficulties inherent in soft
pegs, have been moving. Is this a good idea?
A. The basic case for flexibility
The classical argument by Milton Friedman
(1953) in favour of flexibility still holds much water: if prices move slowly, it is both faster and less
costly to move the nominal exchange rate in response
to a shock that requires an adjustment in the real exchange rate. The alternative is to wait until excess
demand in the goods and labour market pushes
nominal goods prices down. One need not be an
unreconstructed Keynesian to suspect that process
is likely to be painful and protracted. The analogy
that Milton Friedman used is revealing and accurate:
every summer it is easier to move to daylight savings time than to coordinate large numbers of people
and move all activities by an hour.
The case for exchange-rate flexibility is especially strong if the country in question is often
buffeted by large real shocks from abroad. The logic
here is once again due to Mundell – although in this
case it is the somewhat later Mundell (1963) of the
model that linked his name to Fleming’s. If shocks
to the goods markets are more prevalent than shocks
to the money market, then a flexible exchange rate is
preferable to a fixed rate. And, of course, foreign
real variability is likely to be particularly large for
exporters of primary products and/or countries highly
indebted abroad – that is, a profile that fits many
emerging market countries. Indeed, the 1990s produced large fluctuations in the terms of trade and
international interest rates relevant for these countries. Note also that the preference for flexible
exchange rates among countries with a heavy natural resource base extends into the OECD: Australia,
Canada, New Zealand and some of the Scandinavian
countries are good examples.
This old set of arguments in favour of exchangerate flexibility for developing countries has recently
come under attack from a number of fronts. One claim
is that depreciations, like increases in the money supply, only work if they surprise the public. And, of
course, no government can surprise all of the public
all of the time: repeated depreciations only cause
inflation, without real effects. This claim is correct,
but also perfectly irrelevant. The Friedman case for
flexibility certainly does not advocate attempting to
use the nominal exchange rate to keep real activity
away from its natural equilibrium level. On the contrary, it advocates letting the nominal exchange rate
move to adjust relative prices to the new equilibrium
level, after a shock has rendered the old constellation of relative prices obsolete.
A more relevant objection has been raised by
Hausmann et al. (1999). They argue that the classic
case may be right in theory, but wrong in practice for
developing countries. One problem, in their view,
lies in the prevalence of wage indexation. And understanding that nominal depreciation is unlikely to
lead to real depreciation, central banks are reluctant
to use it for counter-cyclical purposes. Another difficulty lies with the classic peso problem: in countries
with a public rendered sceptical by decades of
currency debauchery, movements in the nominal exchange rate tend to be anticipated by changes in
nominal interest rates, so that real rates do not fall
(and may in fact rise) in response to adverse shocks.
Hausmann et al. (1999) test these two claims with
Latin American data, and find some qualified sup-
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
port. Their influential conclusion: exchange-rate flexibility does not deliver much insulation or monetary
policy autonomy, while lacking the credibility value
of a hard peg. Currency boards are therefore a better
option.
This revisionist view has a grain of truth, but
does not generally invalidate the claim that exchangerate flexibility, if properly managed, can be stabilizing.
The key, as with fixed rates, lies in having credibility.
Ongoing depreciations that follow from imprudent
or opportunistic monetary behaviour will surely come
to be expected by agents, and hence will have no
real effect; occasional depreciations that respond
exclusively to unforecastable shocks will, almost by
definition, have real effects.5 The hard part is ensuring that the second case, and not the first, prevails.
Regimes with exchange-rate flexibility are relatively new to Latin America, and were almost always
adopted as the emergency response to an exchangerate crisis (Mexico in 1994 and Brazil in 1999 are
good examples). Moreover, such regimes are run by
central banks that have been legally independent for
only a few years. It therefore seems safe to conjecture that they lack credibility.6 If that is so, the policy
conclusions extracted from the econometric exercises
in Hausmann et al. (1999) are vulnerable to the Lucas
critique. What is being estimated are not structural
parameters linking the exchange rate with real interest rates and real exchange rates, but parameters that
would change if the policy regime changed in the
sense of becoming more credible over time. The degree of wage indexation, for instance, is almost
certainly a function of past inflation rates, and would
probably decline as inflation declines. The experience of countries like Chile, where inflation has been
low for over a decade, offers some support for this
conjecture.
Another way of approaching the same issue is
to focus on the degree of pass-through from exchange
rates to prices. If every movement in the nominal
exchange rate is quickly reflected in an upward adjustment in domestic prices, then the insulation provided by flexible exchange rates is nil, or close to
nil. Both theory and evidence suggest that market
structure and the degree of competition in goods
markets matter crucially for the degree of passthrough. But just as important is whether exchangerate changes are perceived as permanent or transitory
and this, in turn, depends crucially on the average
performance of inflation and monetary policy.
Leiderman and Bufman (1996) investigate the issue
7
empirically for a number of countries (both developed and developing), and conclude:
A different pattern arises in the Latin American countries and Israel, where there is a much
weaker link between nominal and real exchange rates, thus indicating a stronger passthrough than in the foregoing countries. These
facts seem to be consistent with the notion that,
other things being equal, the degree of passthrough is likely to be stronger in a high-inflation environment ...
B. Credibility versus flexibility
The standard theoretical debate on the virtues
of alternative exchange-rate regimes centres on the
alleged tradeoff between credibility and flexibility.
Start from the common assumption that full credibility (technically, doing away from the time inconsistency problem) can only be obtained through a
“hard” fix. Combine that with a setting with pre-set
wages or prices, so that unexpected movements in
the nominal exchange rate can have real effects. Then,
as Rogoff (1985) convincingly showed, there is a
clear tradeoff between the gains from low inflation
and the those from counter-cyclical monetary policy
(see also Velasco, 1996). An irrevocable fix robs a
country of one adjustment tool. If shocks buffeting
an economy are sufficiently large (technically, if their
variance exceeds some threshold), then fixing is not
ex ante welfare-improving. By contrast, if the inflation bias that occurs under discretional monetary
policy is large enough, then flexing is not ex ante
welfare-improving.
The earlier discussion suggests that while this
tradeoff may well be relevant for developed economies, it is not necessarily so for emerging market
economies. In this latter class of countries, credibility appears to be a pre-requisite for flexibility to be
useful. In its absence, as Hausmann et al. (1999) usefully stress, flexibility can be destabilizing.
The crucial policy question, then, is whether a
regime of exchange-rate flexibility is compatible with
sustained monetary credibility, or whether in countries with a weak track record some kind of an
exchange-rate anchor is needed. Conventional wisdom has often chosen the latter option, emphasizing
the political and other costs of reneging on exchangerate commitments. But, as we argued above, neither
theory or empirics are conclusive in this regard.7
8
G-24 Discussion Paper Series, No. 5
Much hinges on the independence with which the
central bank can carry out policy. And in turn this
depends, to a large extent, on the degree of social
consensus regarding the benefits of low inflation.
A number of small open economies have had
successful experiences with exchange-rate flexibility, often coupled with inflation targeting. Australia,
Chile, Colombia, Israel, New Zealand and Sweden
are among them (Leiderman and Bufman, 1996). In
these countries, moderate or low inflation has coexisted with growing degrees of flexibility. In reviewing
the experience of these and other countries experimenting with more flexible arrangements in the early
and mid-1990s, Leiderman and Bufman (1996) conclude: “Despite fears that flexibility and enhanced
monetary policy autonomy would lead to uncontrolled high inflation, there has been a substantial
decrease in the rate of inflation in most countries”.
The more recent experience of Mexico and
Chile is also encouraging. In the years since the 1994
crisis, Mexico has been running a money-based
policy with a de facto dirty float. The same is true of
Chile, where an exchange-rate band has been widened significantly. In both countries the central bank
is legally independent. Several econometric studies
show that in both Chile and Mexico policy has tightened systematically in response to expected inflation,
and since the mid-1990s inflation has been trending
downward.8 Their reaction to the Asian and then the
Russian debâcle is also encouraging. In the course
of 1998 both countries suffered large terms-of-trade
shocks, and their currencies came under pressure.
Both countries allowed moderate depreciation (larger
in Mexico than in Chile), which resulted in some
real depreciation as well. Inflation did not get out of
hand: it continued to fall in Chile, while it temporarily rose and then fell again in Mexico.9 The result
has been a soft landing, with lower but still positive
growth and reduced current-account deficits.10
But the evidence we have is limited. For one,
there are still relatively few developing countries with
dirty floats, and most of these have relatively short
track records. And in many of them, that record is still
contaminated by the abrupt adoption of floating, often in response to a crisis. But since, in response to
the most recent round of crashes, a number of socalled emerging markets (Brazil, the Republic of
Korea and the Russian Federation among them) have
moved to floating, much evidence will be produced
in the near future. Researchers should start sharpening their pencils and readying their computers.
C. Politics and policy-making
At one level, the current enthusiasm for hard
pegs springs from a lack of enthusiasm for developing countries’ ability to build institutions and to
govern themselves soundly. Much of the current
conventional wisdom seems to say: just as war is too
important to be left to the generals, monetary policy
is too important to be left to the central bankers –
especially if they hail from developing countries with
weak political institutions. It is better to adopt a system that removes all discretion from domestic actors
and puts monetary policy on automatic pilot, with
the tough decisions transferred to the presumably
sounder (or at least more politically insulated) bureaucrats in Washington or Frankfurt. In short, the
case for hard pegs rests ultimately on a political argument.
Whether that political argument is correct or
not is an empirical matter. Cynics can easily point to
developing countries were an independent monetary
policy is a chimera; optimists can readily point to
developing countries where the track record suggests
otherwise. More problematic is the fact that, if the
assessment of developing countries’ limited capacity for sound policy-making is empirically correct,
that undermines the whole case for hard pegs. Indeed, it renders it internally inconsistent.
The problem is this. Not even the most enthusiastic advocate of currency boards would deny that
they require soundly supervised banks and prudent
fiscal policies. The literature is littered with calls for
strengthening bank supervision and eliminating
budget deficits before adopting hard pegs. But both
of these prerequisites are technically taxing and politically troublesome. Why should a country without
the political wherewithal to set its interest rate prudently be able to attain them?
Start with financial supervision. It was always
hard, and globalization and innovation have made it
much more so. In recent years, the United States,
Japan and the Scandinavian countries have suffered
financial crashes that could be traced back, at least
partially, to poor regulation. In the summer of 1998,
the near collapse of Long-term Capital Management
revealed a gaping hole in the regulatory arrangements
covering Wall Street. In short, there can be no doubt
that supervising banks is as technically demanding,
if not more so, than implementing monetary policy.
And the political constraints are just as large, as we
learn from the uproar that invariably follows attempts
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
to close insolvent banks or to make good on earlier
promises of no government bailouts. This is exactly
what the recent experience of Ecuador, Indonesia and
Japan, to mention just a few examples, shows.
Much the same may be said about fiscal policy.
Here the technical obstacles are fewer but the political pressures even greater. The record on unsustainable budget deficits is just as checkered for both
developed and developing nations. Theory, both
Keynesian and neoclassical, calls for a larger-thanaverage fiscal surplus at times of economic expansion and a smaller-than-average surplus at times of
contraction. For many developing countries, though,
these prescriptions are a far cry from reality. As a
series of papers produced by the Office of the Chief
Economist of the Inter-American Development Bank
showed, fiscal policy in Latin America has been
clearly procyclical, in contrast both to theory and to
observed behaviour in the OECD (see Gavin et al.,
1996, and references therein).
The problem, once again, has to do with credibility. Policy makers would like to run a countercyclical fiscal policy, but they cannot. Doing so would
involve borrowing large amounts at times of trouble. And, given political institutions, past record of
repayment, the volatility of terms of trade, etc., lenders simply do not lend when the money is most
needed.11 Gavin et al. (1996) provide a useful illustration focusing on the post-Tequila effect experience of Argentina and Mexico:
In 1995 both countries found themselves in
the midst of severe recessions. Despite this,
both countries implemented strongly contractionary fiscal policies, almost certainly
contributing to the depth of the recession and
postponing recovery. This was not done because officials in both countries would not
have liked to implement a more countercyclical policy. It was done because, in light
of investors’ loss of confidence in short-term
prospects, financing of the deficits that would
have been implied by a counter-cyclical policy
was simply not available.
The dilemma facing those who attempt to design policy institutions for developing countries is
stark. If politics prevents a country from managing
its monetary policy soundly, then politics will be
likely to prevent its banks and public finances from
being properly managed as well. In that case, adopting a hard peg solves part of the political problem,
but leaves the country potentially exposed to financial or fiscal crises. And these in time may also erode
the viability of the peg.
9
Alternatively, if a country’s politics and institutions allow bank regulators some autonomy and
legislators some fiscal forethought, then that country can also probably sustain an independent and
credible central bank. And if it can make itself credible in the eyes of investors and markets, should not
that country also be entitled to enjoy the benefits of
exchange-rate flexibility?
D. Exchange-rate flexibility and
financial stability
A major lesson from recent crises in emerging
markets is that financial factors are key in determining an economy’s vulnerability to shocks. Any
advocate of exchange-rate flexibility therefore has
to wrestle with the question of whether it is compatible with financial stability. After all, financial
systems do not respond well to sharp and unforecastable changes in asset prices. Since the exchange rate
is the price of that supremely important asset, domestic money, a regime of flexibility is nothing but
a deliberate attempt to allow this asset price to fluctuate freely. Can this be an invitation to financial
fragility? Yes and no.
The presence of dollar debt is often presented
as an argument against flexibility. Let us suppose that
domestic firms have borrowed in dollars. Suppose,
in addition, that at least some of them are in the nontraded goods sector and have earnings in local
currency, and that the same is true of the government.
Then a nominal devaluation, if successful in the
changing relative prices, drastically increases the
carrying costs of this debt, and can generate a wave of
corporate bankruptcies along with a fiscal crisis. This
danger has been stressed in some interpretations of the
Asian crisis – particularly that of Corsetti et al. (1998).
Calvo (1999) also stresses that “liability-dollarized
economies are highly vulnerable to devaluation”.
But there are a number of important caveats to
this argument. Dollar debt can be hedged and, as discussed in more detail below, a flexible exchange rate
gives borrowers an incentive to hedge that may be
absent under more rigid regimes. In addition, if a
external shock calls for a real depreciation, this will
happen regardless of the exchange-rate system in
place. Policy will only determine the manner of adjustment. Under flexible rates the change in relative
prices occurs suddenly and sharply. Under fixed rates
or a currency board the real depreciation will take
place slowly, as nominal prices fall. Throughout the
10
G-24 Discussion Paper Series, No. 5
adjustment period the real depreciation will be anticipated by markets, and hence domestic real rates
will rise above world rates. And if there are doubts
about the sustainability of the peg, interest rates will
be even higher. At the end of the day, the real value
of debt service will have risen relative to the price of
haircuts. This process can wreck corporate and bank
balance sheets just as surely as a devaluation.
How steep the real devaluation/real interest rate
tradeoff actually is we do not know, and this is certainly a point that cries out for more empirical
research. What seems certain is that the answer will
depend heavily on specific country circumstances:
strength of banks, currency denomination of assets
and liabilities, maturities, degree of hedging, etc.
A real depreciation may be lethal in Indonesia and
the Republic of Korea, where unhedged short-term
foreign debt was the norm; the same is not true of
Chile, for instance, where unhedged short-term foreign debt is minimal.
A related and key point is that the circumstances
that affect the slope of this tradeoff are not God-given,
but often the result of deliberate policy design. One
common culprit is financial liberalization. Radelet
and Sachs (1998) and Chang and Velasco (1998b)
have argued, for instance, that changes in financial
and tax policies in Thailand and elsewhere created
incentives for taking on dollar debt. Similarly, an
insistence on fixing, accompanied by frequent official assurances that exchange rates would never be
devalued, may have discouraged prudent hedging by
private firms. Indeed, observers such as Radelet and
Sachs (1998) have claimed that the Asian pegs may
have fostered a moral hazard problem among borrowers, who felt protected by the official guarantees
on the exchange rate.
Finally, flexible rates may also be helpful in
dealing with financial instability. Chang and Velasco
(1998a) also show that a regime in which bank deposits are denominated in domestic currency, the
central bank stands ready to act as a lender of last
resort and exchange rates are flexible, may help forestall self-fulfilling bank runs. The intuition for this
is simple. An equilibrium bank run occurs if each
bank depositor expects others will run and exhaust
the available resources. Under a fixed rates regime,
those who run to the bank withdraw domestic currency, which in turn they use to buy hard currency at
the central bank. If a depositor expects this sequence
of actions to cause the central bank to run out of dollars or yen, then it is a best response for him/her to
run as well, and pessimistic expectations become self-
fulfilling. On the other hand, under a flexible rates
regime plus a lender of last resort there is always
enough domestic currency at the commercial bank
to satisfy those who run. But since the central bank
is no longer compelled to sell all the available reserves, those who run face a depreciation, while those
who do not run know that there will still be dollars
available when they desire to withdraw them at a
later date. Hence, running to the bank is no longer
the best response, pessimistic expectations are not
self-fulfilling, and a depreciation need not happen in
equilibrium.
In my view this represents a strong (though
surely not overwhelming) case in favour of flexible
exchange rates. But there are caveats. One is that
such a mechanism can protect banks against self-fulfilling pessimism on the part of domestic depositors
(whose claims are in local currency), but not against
panic by external creditors who hold short-term IOUs
denominated in dollars. To the extent that this was
the case in Asia, a flexible exchange-rate system
would have provided only limited protection.12 And
proper implementation is subtle. If they are to be stabilizing, flexible rates must be part of a regime whose
operation agents take into account when forming
expectations. Suddenly adopting a float because reserves are dwindling – as Mexico did in 1994 and
several Asian countries have done more recently –
may have the opposite effect by further frightening
concerned investors.
IV. Making exchange-rate flexibility
work in practice
Giving up a peg, whether of the hard or soft
variety, means that the economy gives up one nominal
anchor. Finding and implementing an alternative anchor
is the first task of advocates of exchange-rate flexibility. Other issues include the optimal degree of intervention in the foreign-exchange market (if any), and
the choice of instrument and rules for conducting
monetary policy. I shall discuss them in turn below.
A. Nominal anchors and inflation targets
The choices for nominal anchor under floating
boil down to two: monetary aggregates or inflation
targets. Among emerging market countries the latter
is by far the most popular. To my knowledge, only
Mexico follows a policy of quantitative targets.
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
The popularity of inflation targets should not
be surprising. Given the instability of money demand
in most economies, targeting aggregates is neither
theoretically optimal nor easy to do in practice. Inflation targets may also prevent the time inconsistency problem that leads to an inflation bias, while
avoiding the pitfalls of fixed exchange rates. And
inflation targets may also have some of the attributes
of hard pegs, in particular transparency and observability. The inflation rate may be published with a lag, but
it is just as accessible and comprehensible to the proverbial taxi driver as is the nominal exchange rate.
As mentioned above, a number of developed
countries, including Canada, Finland, New Zealand,
Spain, Sweden and the United Kingdom, have experimented with inflation target policies of slightly
different sorts. Performance has been reasonably
good, according to most published academic evaluations.13 Inflation targets are less common among
emerging market economies. According to Masson
et al. (1997), “Chile is the country that seems to come
the closest to conducting its monetary policy in a
manner consistent with an inflation target”. Colombia, Indonesia (before the crash), Mexico and the
Philippines have regimes that in some ways resemble an inflation target.14
What is the scope for a more widespread and
successful use of inflation targets among developing
countries? That is a difficult empirical question, on
which much more research is needed. Masson et al.
(1997) identify two requirements for successful inflation targeting in such countries: freedom from
commitment to another nominal anchor like the exchange rate or wages, and the ability to carry out a
substantially independent monetary policy, especially
one not constrained by fiscal considerations. The
former is obviously less constraining to the extent
that many countries are moving towards exchangerate flexibility. There are also grounds to be optimistic
on the second count: legally independent central
banks are increasingly common, and the reliance on
seigniorage to finance government spending has lessened, even in traditionally inflationary regions like
Latin America.
B. Dealing with short-term exchange-rate
fluctuations
The conclusion that a clean float is the only alternative to a hard peg is largely academic. In the
real world clean floats do not exist. Major industri-
11
alized countries such as Canada and the United Kingdom, smaller OECD countries such as Australia and
New Zealand, and middle income countries such as
Peru and Mexico, all practice floating with varying
degrees of “dirt”. Even the United States, usually
regarded as the cleanest of the floaters, intervenes
occasionally in the foreign-exchange market.
The main reason for this is clear. Clean floating means high volatility of nominal exchange rates
– much higher than early advocates such as Friedman (1953) and Johnson (1969) anticipated.15 And,
as Mussa (1986) was the first to point out and many
have documented since, that almost always means
greater volatility of the real exchange rate, for prices
move sluggishly. To the extent that this volatility in
relative prices is costly, either directly or because it
causes volatility in output or in the health of the financial system, policy makers typically want to
mitigate it.
Under inflation targeting there are additional
reasons for managing the exchange rate to some degree. The exchange rate affects inflation through two
channels, as Svensson (1998) has pointed out:
In an open economy, the real exchange rate
affects the relative price between domestic and
foreign goods, which in turn affects both domestic and foreign demand for domestically
produced goods, and hence affects aggregate
demand and inflation.
There is also a direct channel, in that the exchange rate affects domestic currency prices
of imported foreign goods, which enter the
consumer price index.
Hence, any scheme to control the rate of inflation on
the short horizon must control, to some extent, the
behaviour of the nominal exchange rate. That helps
explain the prevalence of managed or dirty floats in
the real world.
C. Dealing with long swings in the
exchange rate
A harder question is whether authorities should
attempt to mitigate not just short-term volatility but
also longer swings in the nominal and real exchange
rate. The question has much practical and empirical
justification. Most observers agree that under floating the exchange rate can be subject to persistent
movements that are only weakly related to funda-
12
G-24 Discussion Paper Series, No. 5
mentals. One often-mentioned example is the behaviour of the dollar in the Reagan years. Obstfeld (1995)
writes: “Exhibit A in the case for irrational exchangerate misalignment has long been the dollar’s massive
appreciation between 1980 and 1985, which amounted
to somewhere between 40 and 60 per cent, depending on the measure used”.
Something similar could be said of the sharp
real appreciation suffered by most Latin American
currencies in the first half of the 1990s. Part of it
could be plausibly justified by the productivity gains
that liberalizing reforms presumably brought; but a
good part of it followed from very large capital inflows, which kept coming because of the expectation
that currencies would appreciate even further. When
expectations reversed, so did the capital flows, and
currencies crashed: Mexico in 1994 and Brazil in
1999.
Such concerns have led to policies to limit exchange-rate movements via flotation bands. And if
such bands crawl, so that their centre remains close
to an estimate of the “equilibrium” exchange rate,
then medium-term misalignment can be avoided.
Avoided, that is, to the extent that the edges of the
band are defensible – and, in the aftermath of the
Asian, Brazilian, Mexican and Russian crises, the
consensus in the profession seems to be that they
cannot be. Bands with “hard edges” eventually fall
prey to the pressures of the market-place.
Williamson (1998) proposes “monitoring bands”
as a possible compromise solution. This is a band
that attempts to target the real exchange rate, but with
a twist. As he puts it:
The key difference between a crawling band
and a monitoring band is that the latter does
not involve an obligation to defend the edge
of the band. The obligation is instead to avoid
intervening within the band (except in a tactical way, to prevent unwanted volatility). There
is a presumption that the authorities will normally intervene to discourage the rate from
straying far from the band, but they have a
whole extra degree of flexibility in deciding
the tactics they will employ to achieve this.
At one level, Williamson’s proposal seems unexceptionable. In practice, most central banks use
bands of this sort in deciding their intervention policy,
although the degree to which they do so explicitly
varies widely. In any managed float, the authorities
are likely to intervene if the exchange rate “strays
too far” from their perceived medium-term equilibrium value.
However, two issues immediately arise. One is
how a central bank can avoid drawing a “line in the
sand”, however fuzzy, if the exchange rate diverges
systematically and in the same direction, from its
estimated equilibrium level. Consider again the case
of several Latin American currencies in the early part
of the 1990s. The central banks of several countries
– including Brazil, Chile and Colombia – were concerned about real appreciation. At the same time they
used fairly broad bands, and were not shy about widening the bands from time to time when market
pressures demanded it. This avoided some of the
problems of hard-edged bands, but not all. On several
occasions markets believed they identified thresholds for central bank intervention, and occasionally
mounted speculative attacks against these perceived
thresholds. When the monetary authorities retreated,
as they often did, some credibility was lost.
The other key question, as Williamson himself
points out, is how much difference such a band would
make to the day-to-day movements in the exchange
rate. The main result of literature on target zones pioneered by Krugman (1991) was that the presence of
the band may be stabilizing (in the sense of making
the exchange rate less responsive to movements in
fundamentals) even when the currency price was well
within the edges of the band. But the less credible or
the less clearly defined the boundaries of the band,
the weaker presumably is this stabilizing effect. Does
a band with very fuzzy edges approach, in the limit,
the workings of a clearly floating exchange rate? The
answer is probably yes, but the issue clearly merits
further research.
D. Crafting monetary policy
How should monetary policy be implemented
and designed in this context? The Taylor rule often
used by central banks provides a natural focus for
the discussion. In such a rule the nominal interest
rate typically depends on the output gap and the deviation of measured or expected inflation with respect
to the target. In the open economy, several interesting issues arise in the design of this rule.
•
Mitigating short-term volatility in the exchange
rate (and thereby in the rate of CPI inflation)
requires that the nominal parity itself be included in the rule, either in rate of change form
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
or in deviations with respect to a target. The
larger the coefficient on this argument, the more
“managed” the exchange rate. As Svensson
(1998) shows, putting the exchange rate in the
Taylor rule is likely to be optimal for most specifications of social welfare function, and especially when shocks are predominantly nominal.
•
•
Targeting quarterly or annual CPI inflation need
not be optimal. This is because in open economies, as we saw above, the exchange rate has a
direct impact on the CPI via import prices. And
to the extent that the nominal exchange rate fluctuates in response to shocks, stabilizing the
short-term CPI inflation could introduce excessive volatility in interest rates and output. An
alternative is to target inflation in the nontradeable sector, which is less influenced by exchange-rate movements; or, as Ball (1998)
suggests, to target a modified inflation index
that filters out the transitory effects of exchangerate movements; or to use an average of CPI
inflation over a longer period.16
Pure inflation targeting, in which only nominal
variables are included in the right-hand side of
the Taylor rule, may well be inferior to a flexible targeting approach in which output or real
exchange-rate deviations are also considered.
This is true in closed economies but even more
so in open economies – again, because nominal
exchange-rate volatility may cause excessive
real volatility. If pure inflation targeting is to
be pursued, it is better to target “long-run” or
average inflation, as Ball (1998) shows.
These are preliminary results, using very general models. Conclusions are quite sensitive to model
specification, the social utility function chosen, and
the relative variance of different shocks. Clearly,
more research is warranted.
V. Complementary policies: financial
regulation, capital controls and
fiscal institutions
Any exchange regime, and especially a flexible
one, requires complementary policies to increase its
chances of success. Some have suggested the use of
controls on capital flows. Less controversial is the
need for prudential regulation of the financial system
and for counter-cyclical fiscal policy. I review briefly
each of these policies in this concluding section.
13
A. Financial liberalization and fragility
We saw above that weak banks can be a main
constraint for monetary and exchange-rate policy.
Only when banks are reasonably healthy can policy
be used freely, without the fear that interest or exchange-rate fluctuations will bring the banking
system tumbling down. Hence, identifying and tackling the sources of financial fragility is crucial for
macro policy makers in developing countries.
In their 1996 paper on the “twin crises”,
Kaminsky and Reinhart (1996) found that: (i) of the
26 banking crises they studied, 18 were preceded by
financial sector liberalization within a five-year interval; and (ii) financial liberalizations accurately
signalled 71 per cent of all balance-of-payments crises and 67 per cent of all banking crises. The
experiences of Chile, Mexico, and now East Asia,
strongly confirm this general tendency. Freeing interest rates, lowering reserve requirements, and
enhancing competition in the banking sector are
sound policies on many grounds – and indeed, countries in which they are applied often experience an
expansion in financial intermediation. But they can
also sharply reduce the liquidity of the financial
sector, and hence set the stage for a potential crisis.
This is the main finding ind Demirguc-Kent and
Detragiache (1998).
Beyond the effects of liberalization on liquidity, a host of other potential ills have been mentioned
in the literature. In particular, deregulation coupled
with explicit or implicit guarantees on banks and inadequate oversight can generate a serious moral
hazard problem. Overlending and excessive risk-taking are likely results, as argued by Velasco (2000)
for the case of Chile and by Krugman (1998) for the
recent Asian episode. A lending boom and growing
share of risky or bad loans often result. As Gavin
and Hausmann (1995) persuasively argue, the empirical link between lending booms and financial
crises is very strong. Rapid growth in the ratio of
bank credit to GDP preceded financial troubles not
just in Chile and Mexico, but also in Argentina
(1981), Colombia (1982–1983), Uruguay (1982),
Norway (1987), Finland (1991–1992), Japan (1992–
1993) and Sweden (1991).17
The moral of the story is the same in both cases.
Financial liberalization should be undertaken cautiously. Reserve requirements can be a useful tool in
stabilizing a banking system, as the experience of
14
G-24 Discussion Paper Series, No. 5
Argentina in 1995 showed. Lowering them to zero,
as Mexico did in the run up to the 1994 crash, smacks
of imprudence.
B. Capital inflows and short-term debt
Short-term government debt proved to be dangerous in the case of Mexico; short-term external
debt has proven to be risky in the case of Asia. In
both cases, runs against this debt ultimately brought
the exchange rate down. What can be done about it?
Restraining short-term borrowing involves no
free lunch, for both governments and banks have
perfectly sound reasons for wanting to make at least
some of their liabilities short-term. At the same time,
it is not clear whether decentralized decision-making delivers the optimal debt-maturity structure:
governments may rely too much on short-term debt
if they suffer from time inconsistency or high discounting; foreign creditors may only be willing to
lend short because of imperfect information or monitoring, or because of coordination failure with other
creditors (if each creditor expects the others will only
lend short, thus making a crisis possible, his best response is also to lend short in order to have a chance
to get out if the crisis comes). These suggest that
there may be a case for a policy discouraging shortterm debt.18
Exactly what policy is a tricky matter. High required reserves on liquid bank liabilities (whether in
domestic or foreign currency, and whether owed to
locals or foreigners) is an obvious choice. It may be
sound policy, even if it has some efficiency costs or
if it causes some disintermediation. An obvious caveat is that if banks are constrained firms will do
their own short-term borrowing, as happened massively in Indonesia. Taxes on capital inflows where
the tax rate in inverse proportion to the maturity of
the inflow (and where long term flows such as FDI
go untaxed at the border) was used by Chile and
Colombia in the 1990s. They are often justified in
terms of findings such as those of Sachs et al. (1996b),
who found that a shorter maturity of capital inflows
was a helpful predictor of vulnerability to the Tequila effect in 1995, while the size of those inflows
was not. Valdés-Prieto and Soto (1996), Larrain et
al. (1997), and Montiel and Reinhart (1997), all find
that the restrictions have affected the maturity composition of flows, though not their overall volume or
the course of the real exchange rate.
C. Improving fiscal institutions
We saw above that excessively procyclical fiscal policies are the inevitable consequence of weak
and deficit-prone fiscal institutions. Lenders do not
lend when times are bad because they do not think
they will be repaid when times are good. This informal view is corroborated by the formal evidence suggestive of fiscal borrowing constraints provided by
Gavin and Perotti (1997). And the weaker the country’s budgetary institutions the greater the problem,
as shown by Gavin et al. (1996).19 The consequence:
fiscal policy is not much use as a counter-cyclical
tool. If monetary policy is not available either – perhaps because of an exchange-rate peg – then countries can be left bereft of a stabilization policy.
A simple and first step forward is to reduce the
levels of public indebtedness. With less initial debt,
there is more room to expand in bad times without
running into borrowing constraints. The ratio of public debt to GDP of East Asian and Latin American
countries is low by OECD standards; but so probably are their credit ceilings, for obvious political
and institutional reasons.
A second step is to reform fiscal institutions to
make spending less cyclical and repayment more
likely. One possibility is the National Fiscal Council
proposed by Eichengreen et al. (1996), which would
give responsibility for the broad trends in fiscal policy
to an autonomous body modelled after independent
central banks. National congresses would still set
spending levels and composition, but the size of the
deficit (or the allowable debt issuance) would be set
by the autonomous Council. If this gave fiscal policy
greater credibility, in the sense of ensuring that deficits today need not mean deficits tomorrow and into
the indefinite future, then fiscal policy would be more
useful as a stabilization tool.
Notes
1
2
3
4
Other recent experiences with a currency board include
Estonia, Lithuania and Bulgaria.
One can think of exceptions. There may be shocks that
are so clearly observable and exogenous that they pass
the test. For instance, Sachs et al. (1996a) argue that the
assassination of presidential candidate Luis Donaldo
Colosio in Mexico in March 1995 could plausibly have
justified the abandonment of the exchange-rate band.
Some coincide with the conditions put forth by Williamson
(1998).
This case is made formally by Herrendorf (1997 and 1999).
Exchange-rate Policies for Developing Countries: What Have We Learned? What Do We Still Not Know?
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
For a formal model that yields this result, see Obstfeld
and Rogoff (1995).
Some empirical evidence suggests exactly this. In the case
of Mexico, increases in the nominal exchange rate are followed by higher nominal interest rates, not lower as the
standard model would suggest. Inflationary expectations
tend to rise as well. One explanation is that agents infer
from temporary depreciations a permanent relaxation of
monetary policy.
Buiter et al. (1998) concur: “Is an exchange-rate commitment more easily established or more credible than a commitment to other nominal anchors? The short answer is
that we have no satisfactory theoretical arguments or empirical evidence to argue convincingly on either side of
the issue”.
On Chile, see Landerretche et al. (1998); on Mexico, see
Edwards and Savastano (1998).
If the real depreciation was not larger, it was not because
of domestic inflation, but because of external deflation.
Mexico grew 7.0 per cent in 1997, 4.8 per cent in 1998,
and is forecasted to grow around 2.8 per cent in 1999.
Chile grew 7.1 per cent in 1997, 3.5 per cent in 1998, and
is likely to expand by 2.0 per cent this year. The current
account was 3.7 per cent of GDP in Mexico in 1998, and
is forecasted at 2.8 per cent for 1999. The corresponding
figures for Chile are 6.2 and 3.5 per cent.
Formalizations of this story rely on the pitfalls of sovereign borrowing, much studied in the 1980s. For a recent
and interesting attempt, see Aizenmann et al. (1996).
Floating is not totally useless in this case, for panic by
foreign creditors could perfectly well be triggered by a
run by domestic depositors, with the outcome being selffulfilling. For details on this line of argument, see Chang
and Velasco (1998a).
See Leiderman and Bufman (1996) and the references contained therein.
Mexico relies mostly on quantitative targets, but also announces an inflation forecast that is meant as a loose guide
to expectations. See Edwards and Savastano (1998).
See the insightful historical discussion in Obstfeld (1995).
Of course, this issue only arises to the extent that the float
is reasonably clean. With active exchange-rate management, targeting CPI and non-tradeables’ inflation should
have practically identical effects.
In Mexico and Chile, as in the case of some Asian countries more recently, the perception of government guarantees may have created a moral hazard problem and led
banks to take on excessive risk. Velasco (1992) discusses
evidence for this in the case of Chile. Krugman (1998)
stresses the role of moral hazard and over-investment in
Asia.
See Rodrik and Velasco (1999) for more details on the
argument.
The quality of fiscal institutions is measured by the index
developed in Alesina et al. (1996).
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17
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March 2000
Arvind PANAGARIYA
The Millennium Round and Developing Countries: Negotiating Strategies and Areas of Benefits
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May 2000
T. Ademola OYEJIDE
Interests and Options of Developing and Least-developed
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May 2000
Andrew CORNFORD
The Basle Committee’s Proposals for Revised Capital
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June 2000
Katharina PISTOR
The Standardization of Law and Its Effect on Developing
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